Chapter 09 - Stock and Their Valuation 1

Stocks and Their
Valuation
Chapter 9
© 2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Overview
Features of Common Stock
Intrinsic Value and Stock Price
Determining Common Stock Values
Discounted Dividend Model
Corporate Valuation Model
Other Approaches
Preferred Stock
Facts About Common Stock
 Represents ownership
 Ownership implies control
 Stockholders elect directors
 Directors elect management
 Management’s goal: Maximize the stock
price
Intrinsic Value and Stock Price
 Outside investors, corporate insiders, and

analysts use a variety of approaches to estimate
a stock’s intrinsic value (P̂0 ).
 In equilibrium we assume that a stock’s price
equals its intrinsic value.
• Outsiders estimate intrinsic value to help
determine which stocks are attractive to buy
and/or sell.
• Stocks with a price below (above) its intrinsic
value are undervalued (overvalued).
Different Approaches for Estimating the Intrinsic Value of a
Common Stock
Discounted dividend model
Corporate valuation model
Models based on market multiples
Discounted Dividend Model
 Value of a stock is the present value of the

future dividends expected to be generated by
the stock.
D1 D2 D3 D
P̂0  1
 2
 3
 ... 
(1  rs ) (1  rs ) (1  rs ) (1  rs ) 
Constant Growth Stock
 A stock whose dividends are expected to grow

forever at a constant rate, g.
D1 = D0(1 + g)1
D2 = D0(1 + g)2
Dt = D0(1 + g)t
 If g is constant, the discounted dividend formula
converges to:
D 0 (1  g) D1
P̂0  
rs  g rs  g
Future Dividends and Their Present Values
$
Dt = D0 (1 + g)t
0.25 Dt
PVD t 
( 1  r )t
P0   PVD t
0 Years (t)
What happens if g > rs?
 If g > rs, the constant growth formula leads to a

negative stock price, which does not make
sense.
 The constant growth model can be used only if:

• rs > g
• g is expected to be constant forever.
Use the SML to Calculate the Required
Rate of Return (rs)
 If rRF = 3%, rM = 8%, and b = 1.2, what is the

required rate of return on the firm’s stock?
rs = rRF + (rM – rRF)b

= 3% + (8% – 3%)1.2
= 9%
Find the Expected Dividend Stream for the Next 3 Years and
Their PVs
D0 = $2 and g is a constant 4%.
0 g = 4% 1 2 3
2.08 2.1632 2.24973

1.9083
rs = 9%
1.8207
1.7372
What is the stock’s intrinsic value?
 Using the constant growth model:
D1 $2.08
P̂0  
rs  g 0.09  0.04
$2.08

0.05
 $41.60
What is the stock’s expected value, one year from now?
 D1 will have been paid out already. So, expected

P1 is the present value (as of Year 1) of D2, D3,
D4, etc.
D2 $2.1632
P̂1  
rs  g 0.09  0.04
 $43.26
 Could also find expected P1 as:

P̂1  P0 (1.04)  $43.26
Find Expected Dividend Yield, Capital Gains Yield, and Total
Return During First Year
 Dividend yield
= D1/P0 = $2.08/$41.60 = 5.0%
 Capital gains yield
= (P1 – P0)/P0
= ($43.26 – $41.60)/$41.60 = 4.0%
 Total return (rs)
= Dividend yield + Capital gains yield
= 5.0% + 4.0% = 9.0%
What would the expected price today be,
if g = 0?
The dividend stream would be a perpetuity.
0 rs = 9% 1 2 3
2.00 2.00 2.00
PMT $2.00
P̂0    $22.22
r 0.09
Supernormal Growth
 What if g = 30% for 1 yr, 20% for 1 yr, and

10% for 1 yr before achieving long-run growth
of 4%?
• Can no longer use just the constant growth
model to find stock value.
• However, the growth does become constant after
3 years.
Valuing Common Stock with Nonconstant Growth
D0 = $2.00.
0 rs = 9% 1 2 3 4
g = 30% g = 20% g = 10% g = 4%

2.600 3.120 3.432 3.5693
2.385
2.626
2.650
55.123 3.5693
P̂3   $71.39
62.784 = P̂ 0.09  0.04
0
Find Expected Dividend and Capital Gains Yields During the
First and Fourth Years
 Dividend yield (first year)

= $2.60/$62.78 = 4.14%
 Capital gains yield (first year)

= 9.00% – 4.14% = 4.86%
 During nonconstant growth, dividend yield and

capital gains yield are not constant, and capital
gains yield ≠ g.
 After t = 3, the stock has constant growth and

dividend yield = 5%, while capital gains yield = 4%.
Nonconstant Growth: What if g = 0% for 3 years before long-
run growth of 4%?
D0 = $2.00.
0 r = 9% 1 2 3 4
s
g = 0% g = 0% g = 0% g = 4%
2.00 2.00 2.00 2.08
1.84
1.68
1.55
2.08
32.12 P̂3   $41.60
0.09  0.04
37.19 = P̂0
Find Expected Dividend and Capital Gains Yields During the
First and Fourth Years
 Dividend yield (first year)

= $2.00/$37.19 = 5.38%
 Capital gains yield (first year)

= 9.00% – 5.38% = 3.62%
 After t = 3, the stock has constant

growth and dividend yield = 5%, while
capital gains yield = 4%.
If the stock was expected to have negative growth (g = -4%),
would anyone buy the stock, and what is its value?
 Yes. Even though the dividends are declining,

the stock is still producing cash flows and
therefore has positive value.
D1 D 0 (1  g)
P̂0  
rs  g rs  g
$2.00 (0.96) $1.92
   $14.77
0.09  (-0.04) 0.13
Find Expected Annual Dividend and Capital Gains Yields
 Capital gains yield

= g = -4.00%
 Dividend yield
= 9.00% – (-4.00%) = 13.00%
 Since the stock is experiencing constant growth,

dividend yield and capital gains yield are
constant. Dividend yield is sufficiently large
(13%) to offset negative capital gains.
Corporate Valuation Model
 Also called the free cash flow method. Suggests

the value of the entire firm equals the present
value of the firm’s free cash flows (which is the
MV of its operations) plus the market value of
its non-operating assets.
 Remember, free cash flow is the firm’s after-tax
operating income less the net capital
investment.
Applying the Corporate Valuation Model
 Find the market value (MV) of the firm’s

operations, by finding the PV of the firm’s future
FCFs.
 Add the market value of the firm’s non-

operating assets.
 Subtract MV of firm’s debt and preferred stock

to get MV of common stock.
 Divide MV of common stock by the number of

shares outstanding to get intrinsic stock price
(value).
Issues Regarding the Corporate Valuation Model
 Often preferred to the discounted dividend

model, especially when considering number of
firms that don’t pay dividends or when
dividends are hard to forecast.
 Similar to discounted dividend model, assumes

at some point free cash flow will grow at a
constant rate.
 Horizon value (HVN) represents value of firm’s

operations at the point that growth becomes
constant.
Use the Corporate Valuation Model to Find the Value of the
Firm’s Operations
0 r = 7% 1 2 3 4
g = 5%
-5 10 20 21.00
-4.673
8.734
16.326
21.00
857.113 1,050   HV3
0.07  0.05
877.500
What is the firm’s intrinsic value per share?
The firm has $40 million total in debt and preferred

stock, $5 million of non-operating assets, and 10
million shares of common stock.
MV of equity  MV of operations  MV of nonoperating assets  MV of debt and preferred
 $877.50  $5  $40
 $842.50 million
Value per share  MV of equity/# of shares

 $842.50/10
 $84.25
Firm Multiples Method
 Analysts often use the following multiples to

value stocks.
• P/E
• P/CF
• P/Sales
 EXAMPLE: Based on comparable firms,
estimate the appropriate P/E. Multiply this by
expected earnings to back out an estimate of
the stock price.
 Enterprise-Based Multiples
• EV/EBITDA
Preferred Stock
Hybrid security
Like bonds, preferred stockholders receive a fixed

dividend that must be paid before dividends are paid to
common stockholders.
However, companies can omit preferred dividend

payments without fear of pushing the firm into
bankruptcy.
If preferred stock with an annual dividend of $5 sells for $100,
what is the preferred stock’s expected return?
D
Vp 
rp
$5
$100 
rp
$5
r̂p 
$100
 0.05  5%
End of Chapter 9
© 2019 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Cover image attribution: “Finance District” by Joan Campderrós-i-Canas (adapted) https://flic.kr/p/6iVMd5

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Chapter 09 - Stock and Their Valuation 1

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Stocks and Their

Features of Common Stock

Intrinsic Value and Stock Price

Determining Common Stock Values

Discounted Dividend Model

Corporate Valuation Model

 Outside investors, corporate insiders, and

Discounted dividend model

Corporate valuation model

Models based on market multiples

 Value of a stock is the present value of the

 A stock whose dividends are expected to grow

 If g > rs, the constant growth formula leads to a

 The constant growth model can be used only if:

 If rRF = 3%, rM = 8%, and b = 1.2, what is the

rs = rRF + (rM – rRF)b

D0 = $2 and g is a constant 4%.

2.08 2.1632 2.24973

 Using the constant growth model:

 D1 will have been paid out already. So, expected

 Could also find expected P1 as:

The dividend stream would be a perpetuity.

2.00 2.00 2.00

 What if g = 30% for 1 yr, 20% for 1 yr, and

g = 30% g = 20% g = 10% g = 4%

 Dividend yield (first year)

 Capital gains yield (first year)

 During nonconstant growth, dividend yield and

 After t = 3, the stock has constant growth and

 Dividend yield (first year)

 Capital gains yield (first year)

 After t = 3, the stock has constant

 Yes. Even though the dividends are declining,

 Capital gains yield

 Since the stock is experiencing constant growth,

 Also called the free cash flow method. Suggests

 Find the market value (MV) of the firm’s

 Add the market value of the firm’s non-

 Subtract MV of firm’s debt and preferred stock

 Divide MV of common stock by the number of

 Often preferred to the discounted dividend

 Similar to discounted dividend model, assumes

 Horizon value (HVN) represents value of firm’s

The firm has $40 million total in debt and preferred

Value per share  MV of equity/# of shares

 Analysts often use the following multiples to

Like bonds, preferred stockholders receive a fixed

However, companies can omit preferred dividend

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